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Pharmaceuticals as a Sectoral Innovation SystemMaureen McKelvey* and Luigi Orsenigo***Chalmers University* University of Brescia and CESPRI, Bocconi University, MilanNovember 2001Paper prepared for the ESSY Project (European Sectoral Systems of Innovation) and within theEpris Project. The authors wish to thank Fabio Pammolli and Massimo Riccaboni: the influence oftheir work and of their ideas is evident throughout the text. Moreover, Nicola Lacetera providedinvaluable research assistance and more.11. IntroductionPharmaceuticals are a large, high-growth, globalized, and innovation intensive industry. Itsproducts – drugs - are directed to satisfy consumer needs in an area – health care – whoseimportance for the society is fundamental and rapidly increasing. Health care and therapeutics areamong the most relevant issues in the definition of the concepts of welfare and democracy in thenew century.Ever since the last century, pharmaceuticals used to be a traditional stronghold of theEuropean industry and it still provides by far the largest contribution to the European trade balancein high-technology sectors. However, over the past two decades the European pharmaceuticalindustry has been losing ground vis-à-vis the United States. Moreover, significant changes havealso been occurring within European countries (Gambardella, Orsenigo and Pammolli, 2000).Indeed, over the last two decades, the world pharmaceutical industry has undergoneprofound transformations. It has been experiencing a series of technological and institutional shocksthat have affected all the stages of the value chain and have led to deep changes in firms’organization and in market structure, within domestic markets, regionally, and globally.At one extreme of the value chain, the advent of what is now known as the “molecularbiology revolution” and the emergence of biotechnology have radically transformed the prospectsand the processes of drug discovery. At the other extreme, the rise of healthcare costs andprescription drug spending has induced a series of cost containment policies, which have beengenerating profound changes in the structure of demand in all major national markets. In between,increasingly stringent requirements for the approval of new drugs have implied larger, more costlyand internationally based clinical trials. Developments in legislation and in courts’ interpretation ofissues concerning intellectual property rights, as well as increasing openness of domestic markets toforeign competition are also having significant impacts on patterns of competition and industrialevolution. Jointly, these tendencies have implied a sharp increase in the resources needed to developnew drugs. Equally important, they have led to a redefinition of the nature and of thecomplementarities between the fundamental sources of competitive advantages in this industry,namely R&D and innovative competencies, marketing and distribution capabilities.Faced with these challenges, both individual firms and national industries have reacted quitedifferently. Companies had to redesign their competencies and strategies. In particular, the risingcosts and the new logic of R&D and marketing have induced processes of Mergers and Acquisitions(M&A), increasing concentration, and globalization of the industry. At the same time, new patternsof division of labour, collaboration among firms and other institutional actors like universities and2public research centers, are emerging. Key competitive assets for individual firms and countries areincreasingly related to knowledge structures as well as the degree of competitiveness andinternationalization. These competitive assets include - but are not limited to - the availability offirst rate scientific research within universities and other public research centers, the structure of thesystems of biomedical research, the patterns of inter-firm alliances in marketing and research.This chapter analyzes pharmaceuticals and the new biotechnology-pharmaceutical overlapthrough the lens of a sectoral system of innovation (SSI). Intuitively, the pharmaceutical industryquite naturally lends itself to be analyzed as a Sectoral System of Innovation or as a network (seeGalambos and Sewell, 1996; Chandler 1999). However, at the same time and precisely given theintuitive appeal of the notion of “system” and/or “network” for this industry, taking this approachforces the researcher to try to make this notion more precise and compelling and – above all – toSectoral Innovation System approach” useful. This constitutesthe general aim of this paper. For the time being, we start from the provisional definition proposedby Franco Malerba in his contribution to this project:A sectoral system of innovation and production is composed by the set ofheterogeneous agents carrying out market and non-market interactions forthe generation, adoption and use of (new and established) technologies andfor the creation, production and use of (new and established) products thatpertain to a sector (“sectoral products”).Generically, the pharmaceutical industry can be easily considered as a system or a networkbecause innovative activities involve directly or indirectly a large variety of actors, including:(different types of) firms, other research organizations like universities and public and privateresearch centers, financial institutions, regulatory authorities, consumers.All these actors are different in many senses. They know different things, they have differentincentives and motivations, they have different rules of action.All these actors are linked together through a web of different relationships. Starting from astandard economic approach, such relations are quite varied, as they include almost pure markettransactions, command and control, competition, collaboration and cooperation and all sorts of theso-called “intermediate forms”. Already at this extremely simplistic level of discussion, thepharmaceutical industry looks quite interesting because some – if not most – of these relationshipshave a peculiar nature. The obvious example is the observation that the market for drugs ischaracterized by strong informational asymmetries. Consumers cannot properly evaluate the3quality of a drug; those who select a particular drug for a specific consumer do not coincide withthose who pay for the drug, etc.. Another obvious example is given by the relationships betweenuniversities and other research institutions on the one hand and industry on the other. These agentsact following different logics, incentives and goals, which may often conflict. The interaction isaffected by the actions of regulatory authorities, e.g. patent laws, incentives to academics to engagein commercial activities, etc.. In particular, in this industry, one observes the mix and partialoverlapping of different selection principles. As we shall argue, the emergence of hybrid forms ofselection and learning (Mc Kelvey, 1997) is one of the most interesting features of this industry inrecent years.In this paper, we try to articulate this perspective addressing four issues, which link ourempirical analysis of this sector with theoretical arguments. These four issues are:- First, the relative importance of these actors and the specific form of the linkages between theactors differs over time and across countries.- Second,this system has been changing over time through the emergence of new agents and ofnew relations, and through changes in the intensity of these relationships.- Third, the key capabilities and competitive assets have changed, due to environmental selectionpressures as well as to internal firm actions.- Fouth, this in turn implies that patterns of competition and selection processes have alsochanged in the international pharmaceutical sectoral system of innovation.Rather than identify and map each national element within European countries or moreinternationally within the pharmaceutical sectoral system of innovation, this chapter instead selectsa subset of problems and conceptual issues to analyze. The boundaries of our analysis can be set asfollows:a) First, we do not focus on the entire history of the industry, but only on a recent period. Inparticular, although we sketch the evolution of the industry prior to the mid Seventies, as abackground for the following analysis, we examine mainly the evolution of thepharmaceutical industry over the last 20/25 years. That is to say, we concentrate on theimpact of the molecular biology revolution and – to a lesser extent – on the effects of cost-containment policies. The main reason for this choice is that these major changes in supply,demand and knowledge development have profoundly modified the structure of therelationships among firms and the other agents that define this sectoral system of innovation.b) Second, we focus on the dynamics of the system. Rather than trying to provide a detailedexamination of the structure of the system at a given point in time, we concentrate on tryingto make some steps in understanding how the system evolves over time, both in response to4“external shocks” and as a result of endogenous developments in the network itself. Thisattitude reflects the basic methodological stance that the notion of sectoral systems ofinnovation has an intrinsic dynamic and evolutionary connotation and that – in order tounderstand why a specific structure takes a particular form – one has to understand thedynamic processes that generated it. We look at industry evolution as a dynamicdisequilibrium and evolutionary processes, a process of imperfect adaptation through theconstruction and reconfiguration of organizational capabilities.c) Third, we focus on the changing nature of the relationships among selected agents, ratherthan on specific agents. Relationships are obviously at the heart of sectoral system ofinnovation, with the idea that no firm innovates in isolation but is instead an integral actorwithin collective market and knowledge processes. For these reasons, we try to reconstructand to understand how differentiated forms of interaction among agents have changed overtime and why.d) Fourth, we focus on the interaction between cognitive/technological factors andinstitutional/country-specific factors that shape the evolution of the pharmaceutical systemof innovation. Both factors are clearly relevant, and one contribution here is to analyze howand why both meet and shape pharmaceutical competition. On the one hand, changes in theknowledge base and in the relevant learning processes have induced deep transformations inthe behaviour and structure of the agents and in their relationships among each other. On theother hand, the specific way these transformations have occurred across countries has beenprofoundly different, in relation to the details of the institutional structure of each country.Understanding how technology and institutions co-evolve is a major aim of this paper.The analytical arguments for including institutions and incentives influencing demand, supplyand knowledge development are that these three together form the specific innovation opportunitiesfor pharmaceuticals. Moreover, the specific innovation opportunities for pharmaceuticals are alsoshaped by the actions of individual firms and of groups of firms. Thus, firms also shape theseinnovative opportunities through their forward looking decisions, strategies, actions as well as pastcompetencies. Nevertheless, we argue that on the one hand, it is reasonable to group firms relativeto their reactions to specific national selection environments, while on the other hand, firms will notreact identically to such environments, leading to some diversity within a group of firms.Thus, we compare the evolution of the sectoral systems of innovation in pharmaceuticals in theUSA and in Europe. In particular, the Continental European pharmaceutical sectoral systems ofinnovation differs in significant ways from the Anglo-Saxon ones. The focus here will be on thelarger Central European countries of Germany, France, Italy compared to US and UK. These5historically rooted differences are visible and impact firms in significant ways, despite stronginternational links and international trends.Our view of the pharmaceutical sectoral system of innovation combines analyticalperspectives based on theory with rich empirical material. We do not present here directly newempirical evidence and data. Rather, we rely on secondary sources (some of it provided by theauthors), to which readers are referred .Specifically, the paper is organized as follows. In Section 2, we briefly recount the mainfeatures of the development of the pharmaceutical industry until (more or less) the Mid-Seventies.We discuss in particular the interactions between the nature of the learning regimes and the relatedforms of organization of innovative activities; the patterns of competition and the nature of firms’and countries competitive advantages; the forms of regulation and the structure of demand.In Section 3, we move to the more recent history. Here, we discuss how the changes in theknowledge base and in the technological regime induced by the advent of the Molecular BiologyRevolution on the one hand and by the transformations in the regulatory environment and indemand on the other have drastically reconfigured the sectoral system of innovation. First, we lookat the American case. Then, against this background, we discuss the main factors that might havecaused a decline in European competitiveness.On these grounds, Section 4 tries to link historical evidence with more theoretically orientedanalysis. In this final section of the paper, some conclusions and hypotheses are suggested whichrelate to the general concept of a sectoral system of innovation and are applied both to the specificsof pharmaceuticals and the specifics of Europe.2. Innovation and the evolution of the sectoral system of innovation in the pharmaceuticalindustry: an overviewThe patterns of development of the pharmaceutical industry have been extensively analyzedby several scholars. Rather than telling the same story once again, we pick up some particularlyimportant and relevant themes for our argument. This section relies especially on the work byChandler 1990 and 1998, Galambos and Sewell 1996, Galambos and Sturchio 1996, Gambardella1995, Lamoreaux and Galambos 1997, Orsenigo 1989, Schwartzman 1976 and above allHenderson, Orsenigo and Pisano, 1999. These references have, however, been used to give aninterpretation of the history of the pharmaceutical industry in terms of our evolutionary approach tosystems of innovation (McKelvey 1997).6In very general terms, the history of the pharmaceutical industry can be analyzed as anevolutionary process of adaptation to major technological and institutional “shocks”. These shockshave occurred both endogenously and exogenously to the sector, and they include our threedimensions of supply, demand and knowledge development. While radical changes seem tocharacterize change within this sector, past interrelated shocks can be useful to divided modernhistory into three major epochs. The first epoch is roughly the period 1850-1945. The second epochis roughly the period 1945 to the early 1980s. The third epoch is from the early 1980s through thepresent time.2.1 The early stages of the pharmaceutical industryThe first epoch corresponds roughly to the period 1850-1945. This is the period where drugswere closely related to chemicals, especially with the emergence of the synthetic dye industry inGermany and Switzerland. In terms of novelty generated, this epoch was one in which little newdrug development occurred, and in which the minimal research that was conducted was based onrelatively primitive methods. Initially, Swiss and German chemical companies such as Ciba,Sandoz, Bayer, and Hoechst leveraged their technical competencies in organic chemistry anddyestuffs in order to begin to manufacture drugs (usually based on synthetic dyes) later in 19thcentury. Up until World War I German companies dominated the industry, producingapproximately 80% of the world’s pharmaceutical output.Nevertheless, firms in other geographic localities were also moving into pharmaceuticals. Inthe U.S. and the U.K., mass production of pharmaceuticals also began in the later part of the 19thcentury. However, whereas Swiss and German pharmaceutical activities tended to emerge withinlarger chemical producing enterprises, the U.S. and U.K. witnessed the birth of specializedpharmaceutical producers such as Wyeth (later American Home Products) Eli Lilly, Pfizer,Warner-Lambert, and Burroughs-Wellcome. As organizational forms, these were more specializedand independent drug producers, rather than an integral part of chemical companies.Overall in these early years, the pharmaceutical industry was not tightly linked to formalscience nor characterized by extensive in-house research and development (R&D) for new drugs.Until the 1930s, when sulfonamide was discovered, drug companies undertook little formalresearch. Most new drugs were based on existing organic chemicals or were derived from naturalsources (e.g. herbs) and little formal testing was done to ensure either safety or efficacy. However,the emerging sectoral system of innovation comprised already not only firms, but quite obviouslyalso universities and – to a lesser extent, since regulation was not strongly developed - regulatoryauthorities. Universities provided the basic knowledge in chemistry and – most importantly – the7inflow of trained chemists necessary to sustain innovation. Similarly, patent laws (where available)provided both the incentives and the context for innovation.Moreover, linkages among firms quickly developed due to the exchanges of licences forproduction and marketing of drugs. These licensing relationships are important for the industrialstructure of the sector, because they helped create differentiated categories of pharmaceutical firms.Indeed, ever since its inception, the industry has been comprised of – at least – two types of firms.A first group of companies focused relatively more on innovation and drug discovery, and thisgroup included the German and Swiss giants and some American companies like Merck, Pfizer(see Chandler, 1998). These companies have been focused on first mover advantages through drugdiscovery and commercial exploitation. A second group of firms has instead specialized in beingfollowers in the sense of imitating / inventing around products invented elsewhere and/or productssold over-the-counter. This group of firms included companies like Bristol-Myers, Warner-Lambert, Plough, American Home Products as well as most of the firms in countries like France,Italy, Spain and Japan. Both groups of companies have developed their own types of production andmarketing competencies, but the main differences seem to be in overall strategies for innovations.2.2 The “Random Screening” periodThe second epoch runs approximately from 1945 to the early 1980s, where the golden age ofpharmaceuticals began in earnest after World War II. During the war, the U.S. and Britishgovernments organized a massive research and production effort that focused on commercialproduction techniques and chemical structure analysis. More than 20 companies, severaluniversities, and the Department of Agriculture took part in the Anglo-Saxon effort. Thecommercialization of penicillin marked a watershed in the industry's development. Due partially tothe technical experience and organizational capabilities accumulated through the intense wartimeeffort to develop penicillin, as well as to the recognition that drug development could be highlyprofitable, pharmaceutical companies embarked on a period of massive investment in R&D.Companies built large-scale internal R&D capabilities. At the same time there was a verysignificant shift in the institutional structure surrounding the industry. First, whereas before the war,public support for health related research had been quite modest, it boomed to unprecedented levelsafter the war. Thus, science push and science connections began in earnest. Second, thedevelopment of the Welfare State - especially of National Healthcare systems - provided a rich,“organized” and regulated market for drugs, even if obviously the features varied drastically acrosscountries.8In this period, the German and Swiss industries remained top innovators and continued todominate the industry. Indeed, it is worth remembering that, despite the requisition of Germanpatents at the end of the war, the big German giants which emerged after the split-up of IG Farben,regained their leadership very quickly. In these and other countries, smaller and less innovativefirms prospered in their domestic markets, through processes of imitation, inventing-around and theproduction and marketing of drugs under license or after patent expiration. However, in the post-war years the American industry joined the core of the worldwide industry leaders and startedgradually to set the stage for its subsequent dominance. We suggest some possible explanations forthese trends in the following paragraphs.2.2.1 The organization of R&D and the patterns of competitionThis second epoch was a golden age for the pharmaceutical industry. R&D spendingliterally exploded, which also led to a steady flow of new drugs. Drug innovation was a highlyprofitable activity for innovating firms during most of this period. Up to the early 1980s, doubledigit rates of growth in earnings and return-on-equity were the norm for most pharmaceuticalcompanies, and the industry as a whole ranked among the most profitable in the United States andin Europe.A number of structural factors supported the industry's high average level of innovation andeconomic performance during this second epoch. One factor was the sheer magnitude of both theresearch opportunities and the unmet needs. In the early post-war years, there were many physicalailments and diseases for which no drugs had previously existed. In every major therapeuticcategory -- from pain killers and anti-inflammatories to cardiovascular and central nervous systemproducts -- pharmaceutical companies faced an almost completely open field. Remember thatbefore the discovery of penicillin, very few drugs effectively cured diseases. This situation can becalled a target rich environment, in the sense that many possible targets were available - withattenuate high probabilities of success.Faced with such a "target rich" environment but with very little detailed knowledge of thebiological underpinnings of specific diseases, pharmaceutical companies invented an approach toresearch now referred to as "random screening." Under this approach, natural and chemicallyderived compounds are randomly screened in test tube experiments and laboratory animals forpotential therapeutic activity. Pharmaceutical companies maintained enormous "libraries" ofchemical compounds, and they added to their collections by searching for new compounds in placessuch as swamps, streams, and soil samples. Thousands of compounds might be subjected tomultiple screens before researchers honed in on a promising substance. Serendipity played a key9role since in general the "mechanism of action" of most drugs were not well understood.Researchers generally relied on the use of animal models as screens.Under this regime it was not uncommon for companies to discover a drug to treat onedisease while searching for a treatment for another. Still, search was directed by the limitations ofsearch itself. Since even the most productive chemist might find it difficult to synthesize more thana few compounds over the course of a week, researchers tended to focus their attention onsynthesizing variants of compounds that had already shown promising effects in a screen, but thatmight not be ideally suited to be a drug. Important limiting factors in this target rich environmentwere that any given compound might have unacceptable side effects or be very difficult toadminister. While chemists working within this regime often had some intuitive sense of the linksbetween any given chemical structure and its therapeutic effect, little of this knowledge wascodified, so that new compound "design" was driven as much by the skills of individual chemists asit was by a basis of systematic science.The "design" of new compounds was a slow, painstaking process that drew heavily on skillsin analytic and medicinal chemistry. Several important classes of drugs were discovered in this way,including most of the important diuretics, many of the most widely used psychoactive drugs andseveral powerful antibiotics. This nature of the processes of drug discovery and development had animportant impact on the patterns of competition and on market structure in that innovative R&Dintensive companies were profitable and competitive. Competition and market structure are in turndependent on the strategies and fortunes of individual companies, which are sometimes linked todifferent national contexts and sometimes part of international trends.Indeed, random screening worked extremely well for many years. Several hundred newchemical entities (NCEs) were introduced in the 1950s and 1960s, and several important classes ofdrug were discovered in this way. The outcome in terms of medicine was thus significant andincreased the supply and diversity of drugs available to treat diseases. Nevertheless, the searchprocess itself was rather inefficient, and so the successful introduction of NCEs has to be consideredas a quite rare event. Estimates suggest that, out of all new compounds that were tested only one outof 5,000 reached the market. The rate of introduction was on the order of a couple of dozens peryear, and these were concentrated in some fast-growing areas such as central nervous system,cardiac therapy, anti- infectives and cytostatics. In short, innovative new drugs arrived quite rarelybut after the arrival they experienced extremely high rates of market growth. In turn, this entailed ahighly skewed distribution of the returns on innovation and of product market sizes as well as of theintra-firm distribution of sales across products. So a few `blockbusters' dominated the product range10of all major firms (Matraves, 1999, p.180; Sutton, 1998). The firms were dependent on thesesingularly successful products, which also had rapidly growing markets.The success of this way of organization of the innovation process led to a favoring of certaintypes of innovations (McKelvey forthcoming), which was reinforced by mechanisms ofappropriability of the potential profits deriving from innovation. Pharmaceuticals has historicallybeen one of the few industries where patents provide solid protection against imitation (Klevorick etal. 1982). Firms wishing to succeed in pharmaceuticals through this type of blockbuster drugstrategy had very strong incentives to be the first innovators, holding the patents. Because smallvariants in a molecule's structure can drastically alter its pharmacological properties, potentialimitators often find it hard to work around the patent. Although other firms might undertakeresearch in the same therapeutic class as an innovator, the probability of their finding anothercompound with the same therapeutic properties that did not infringe on the original patent could bequite small. Thus, being second could mean losing out - at least until patent expired and analternative strategy of imitation could be carried out by some firms.Note, however, that the scope and efficacy of patent protection has varied significantlyacross countries. The U.S have provided relatively strong patent protection in pharmaceuticals.However, in many other European countries, including Germany, France, Germany, Italy, Japan,Sweden and Switzerland did not offer protection for pharmaceutical products: only processtechnologies could be patented. France introduced product patents in 1960, Germany 1968, Japan1976, Switzerland 1977, Italy and Sweden in 1978. In some cases, as in Japan and Italy (andpossibly France) the absence of product patent protection induced firms to avoid product R&D andto concentrate instead on finding novel processes for making existing molecules. In other cases,primarily Germany and Switzerland, this negative effect didn’t happen. More generally, theseobservations suggest the conjecture that strong patent laws do indeed confer an advantage toinnovators, but they are not enough to promote innovation in contexts where innovative capabilitiesare low or missing altogether. Similarly, high degrees of appropriability are likely to be particularlyimportant for sustaining innovation in highly innovative and competitive environments, rather thanin situations where little innovation takes place anyhow. In other words, patents magnify theincentives to innovate, but do not create them, in the absence of the competencies that makeinnovation possible in the first place. Thus, strong incentives can create virtuous circles when theyare coupled with strong competencies, but they might be ineffective and even dangerous when thelatter are insufficient. The opposite is also likely to be true: competencies without incentives areprobably bound to be underutilized and wasted.11In addition to external national institutions, however, factors internal to specific firms alsoclearly affected the survival of certain firms - in terms both of their ability to continue - and successat - competing over time. Such factors also affect the ability for firms outside the industry to enter.The organizational capabilities developed by the larger pharmaceutical firms may also have actedas a mechanism of appropriability. Consider, for example, the process of random screening itself.As an organizational process, random screening was anything but random. Over time, early entrantsinto the pharmaceutical industry developed highly disciplined processes for carrying out massscreening programs, which require systematic search strategies as well as handling large amounts ofdata in a sophisticated manner. Because random screening capabilities were based on internal to thefirm organizational processes and tacit skills, they were difficult for potential entrants to imitate andthus became a source of first-mover advantage. In addition, for random screening, spillovers ofknowledge between firms were relatively small, so firms already having an advantage couldmaintain that advantage over time as compared to firms wishing to enter. Since these firmsessentially rely on the law of large numbers, there is relatively little to be learned from thecompetition, but much to be learned from large scale screening in-house. Each firm needed accessto the appropriate information infrastructure for their therapeutic areas.However, entirely new products (New Chemical Entities) only capture a part of innovativeactivities, even in this second epoch. Other ways of innovating and appropriating economic returnswere also important, both to a second group of firms as well as to leading innovating firms.“Inventing-around" existing molecules, or introducing new combinations among them, or newways of delivering them, etc., constituted a major component of firms’ innovative activities broadlydefined. Thus, while competition centered around new product introductions, firms also had tocompete through incremental advances over time, as well as imitation and generic competition afterpatent expiration. This latter in particular allowed a large “fringe" of firms to thrive throughcommodity production rather than radical innovation. Generations of new markets and ofdiversification across product groups was followed by processes of incremental innovation,development of therapeutic analogues, imitation, licencing. One reason that both the first-comerinnovators and other early innovators could steadily grow in this second epoch was the quicklyexpanding markets, for specific drugs and for pharmaceuticals as a whole.Again, internal to the firm factors could give competitive advantage because the firm couldorganize and control a series of related assets necessary for economic appropriation of innovation -or of imitation. This is because the successful exploitation of the economic benefits stemming frominnovation also required control over other important complementary assets. These included, inparticular, competencies in the management of large-scale clinical trials, in the process of gaining12regulatory approval, in marketing and distribution. Taken together with strong incentives to be firstinnovator with solid patents, these factors also acted as powerful barriers against entry into theindustry.As a consequence of these selection pressures on individual firm choices, the internationalpharmaceutical industry has been characterized by a significant heterogeneity in terms of firms’strategic orientations and innovative capabilities. The “innovative core" of the industry has beencomposed by the early German innovative entrants, which were joined after World War II by a fewAmerican and British firms. These maintained an innovation-oriented strategy over time with bothradical product innovations and incremental product and process innovations. A second group offirms - either located in these countries or more likely in other countries like continental Europe andJapan - specialized instead in imitation, minor innovations and marketing.Likely due to the above pressures, the international industrial structure was rather stable upto the mid-1970s, with very few entrants. The reasons explaining this are the mechanisms providingthe appropriability of innovations, combined with the presence of scale economies inpharmaceutical research, and marketing. Indeed, many of the leading firms during this period --companies like Roche, Ciba, Hoechst, Merck, Pfizer, and Lilly -- had their origins in the"pre-R&D" era of the industry. At the same time, until the mid-1970s only a small number of newfirms entered the industry, and even fewer could enter the “core" of successful innovative firms.Despite this stability in industrial structure, pharmaceuticals has been a series of fragmentedmarkets. The industry was characterized by quite low levels of concentration, both at the aggregatelevel (the pharmaceutical industry) but also in the individual sub-markets like e.g. cardiovascular,diuretics, tranquilizers, etc.Finally, in this period the pharmaceutical industry started to become truly international. Thehigh weight of sunk costs in R&D and marketing implied expansion into new markets to reduceaverage costs. Moreover, the presence in foreign markets was often necessary for complying withlocal regulation. Not particularly surprising, it was the largest, highly R&D intensive German,Swiss and American companies that proceeded more decisively in their international expansion,establishing also networks of relations with local firms through licensing and commercializationagreements.2.3 Changes in the network of relationsIn this second epoch, the network of relations defining the pharmaceutical sectoral system ofinnovation underwent deep transformations. Still, rather than a drastic change in the structure of thenetwork, relationships among agents became denser and thicker.13A continuing analysis of this second epoch based on our four original issues brings us backto the issues of co-evolution of supply, demand and knowledge development. Two points areparticularly important to consider during this second epoch, mainly because they lay the foundationfor understanding the transformation into the third epoch, from the early 1980s. These two pointsrelate to the co-evolution of market, institutions and knowledge. The first point is that newchallenges and opportunities arose, not least due to investments in basic medical science, majorchanges in drug regulation, and the increases in final demand due to collectivized health care. Thesecond point is that the differing positions of countries in respect to these three factors apparentlyled to different reactions among their constituent populations of firms. The evidence presented heremainly compares and contrast continental European countries with the Anglo-Saxon experience,although some evidence about the small, open economies with high knowledge investment are alsopresented in order to return to their different paths of development in the conclusions.2.3.1 Biomedical research: funding and organizationA first change during the second epoch which would fundamentally affect thetransformation to the third epoch concerns fundamental research and industry-university relations. Itwas in these years that the American research system started to gain an absolute leadership inscientific research. Before the war young Americans interested in starting a scientific career went toEurope to specialize and to get access to leading edge science, while in the post-war period thesituation quickly reversed (see among others, Rosenberg and Nelson, 1994). Many good Europeanscientists relocated, of course, to the USA due to the wartime situation. In the specific case ofbiomedical research, in this period, linkages with universities and basic research consolidated andstarted to change their nature, as a consequence of the increase in public spending for biomedicalresearch and due to the introduction of more demanding procedures for products approval. From theperspective of pharmaceutical firms, they needed access to systematic clinical testing, which wasusually organized through the medical research system as well as to fundamental scientific resultswhich increased the biological understanding of diseases, drugs, and cures. Increasing biologicalunderstanding should increase the efficiency of the firm's own internal R&D search processes aswell as form the types of collaboration necessary to monitor external knowledge developments.Nearly every government in the developed world supports publicly funded health relatedresearch, but there are very significant differences across countries in both the level of supportoffered and in the ways in which it is spent. In the US, public spending on health related researchtook off soon after the second world war.Public funding of biomedical research also increased dramatically in Europe in the post-warperiod, although total European spending did not approach American levels (and, after the end of14the war, UK government expenditures on biomedical research were significantly lower than in mostother OECD countries (Thomas, 1994). There is little question that the sheer amount of resourcesdevoted to biomedical research in the USA in the post-war era goes a long way to explain theAmerican leadership in life sciences. The American money was also more concentrated to centersof excellence, thereby providing critical mass of researchers - while also the sheer diversity of theAmerican research system allows many alternatives to be tested early on. Both qualitative andquantitative evidence suggests that this spending has had a significant effect on the productivity ofthose large US firms that were able to take advantage of it (Ward, Dranove, 1995; Cockburn,Henderson, 1996; Maxwell, Eckhardt, 1990). As a consequence - and despite the existence ofcenters of absolute excellence - the overall quantity and quality of scientific research lagged behindin Europe. In turn, this created a vicious circle, with a significant drain of human and financialresources from Europe to the USA, which contributed to further strengthen the Americanadvantage.In addition, the institutional structure of biomedical research evolved quite differently inContinental Europe as opposed to the USA (and partly to the UK). By institutional structure, wemean how the flow, level, and direction of research resources are organized - where this in turn isassumed to affect the science done in the respective national contexts. First, the structure of thefunding system and the strategies of the funding agencies are crucially important to influenceresearch results, and these differ between USA and Europe. In the USA, most of the funding isadministered through the NIH, although a significant fraction goes to universities and an importantfraction of the support does go towards basic or fundamental science that is widely disseminatedthrough publication in the refereed literature. Still, the orientation towards health is implicit whennot explicit. Moreover, the American system has been characterized by a variety of sources offunding and selection mechanisms, which complement the role of the NIH and act – always startingfrom scientific excellence - according to different allocative principles. This approach introducessome form of competition between financiers, and so it allows diversity to be explored, while alsomaintaining this emphasis on quality, fundamental science. This enables institutional flexibility.In Europe, funding has been administered mainly at the national level, with stronglydifferentiated approaches and wide differences across countries. This is likely to have hindered thedevelopment of a critical mass of research in key fields, especially in smaller countries. Countriesmay also focus on non-critical research. In many cases, resources have either been dispersed amonga large number of “small” laboratories, or have been excessively concentrated in the few availablecentres of excellence. It is widely recognized that the absolute size and the higher degree of15integration of the American research system, as opposed to the fragmented collection of nationalsystems in Europe constitute a fundamental difference between the research systems.In addition to differences in the allocatory principles for scientific research, the institutionalstructure of biomedical research itself evolved quite different in Continental Europe as opposed tothe USA and the UK. In particular, biomedical research in Europe was much less integrated withteaching and within universities in Continental Europe, with the result that medical research hastended to have a more marginal role compared to patient care. In other words, this organizationalstructures - combined with pressures from cost containment in welfare states - led to an emphasis totreat patients, not learn more about them.The relevance of the research-teaching nexus in favouring high quality scientific researchand its integration with industrial research can hardly be underrated. In particular, the diffusion ofmolecular biology into general training in many European countries is a relatively recentphenomenon as compared to the USA and it has only recently become a standard part of thecurriculum of pharmacologists, pathologists and medical consultants. In Europe, research tended tobe confined into highly specialized laboratories in universities and especially in public researchcenters, with little interaction with teaching, medical practice and, a fortiori, with industrialresearch.Different patterns are visible in different European national contexts. In the UK biomedicalresearch is conducted mainly in the medical schools. The Department of Health and the Departmentfor Education and Science - particularly through the Medical Research Council (MRC) - have beenthe main funding agencies. During the third epoch, private foundations such as the Wellcome Trusthave also emerged as major sources of funding. The MRC funds internal and especially externalresearch at universities (approximately two thirds of the total), a much larger proportion than inFrance. More generally, around the NHS (which was extended to the whole population in 1948) adense web of close interactions was created between academic research, companies and medicalpractice. As Thomas (1994) discusses, this system was strongly science-oriented, elitist and aboveall promoted the informal sharing of control among government the medical profession andindustry.In France, in contrast, biomedical research is largely performed by CNRS and especiallyINSERM, which was founded in 1964 to strengthen basic research in the field. In Germany themain actors in biomedical research are the DFG (Deutsche Forschungsgemeinschaft) and the MPG(Max Planck Gesellschaft). DFG funds external research, while MPG receives funds from thefederal and state governments for conducting essentially internal research. After 1972 the newlyfounded Ministry of Science and Technology (BMFT) emerged as a major actor, sparking16sometimes bitter conflict with the other agencies and with universities, particularly with the socalled "big science centers" which carry out independent research in a limited number of fields.Other, perhaps less tangible, factors have interacted in Continental Europe to create anenvironment which taken as a total together not only produces less science of generally lowerquality but also one in which science is far less integrated with medical practice and industrialconcerns.First of all, in Continental Europe within the medical profession, in general science did notconfer the same status that it did within the Anglo-Saxon countries. Traditionally the medicalprofession in Continental Europe has had less scientific preparation than is typical in either the UKor the USA. Medical training and practice have focused less on scientific methods per se than on theability to use the result of research (Ben-David, 1977, Clark, 1994, Thomas, 1994). Moreover PhDsin the relevant scientific disciplines have been far less professionally-orientated than in the USA orEngland (Ben-David, 1977; Braun, 1994). Partly as a consequence, medically oriented researchwithin universities has tended to have a marginal role as compared to patient care. Historically theincentives to engage in patient care at the expense of research have been very high: France orGermany have only recently implemented a full time system designed to free clinicians from theirfinancial ties to patient-related activities. The organizational structure of medical schools has beensuch as to reinforce this effect. In Continental Europe medical schools and hospitals are part of asingle organizational entity, whereas in the USA and the UK they are autonomous actors, whichperiodically negotiate as to the character of their association. In principle, the European systemshould have a number of advantages with respect to research and teaching. In practice, theEuropean system has tended to have negative consequences as patent care has tended to absorb thelargest fraction of time and financial resources. In these systems, resources are not usually target tospecific activities and given the difficulty of quantifying their cost, even when a fraction of thesubsidies provided by the government are supposed to be used for purposes of research andteaching, patent care easily makes inroads into these supposedly "protected" resources (Braun,1994).The weakness of the research function within hospitals in Continental Europe was one of thereasons that the decision was made to concentrate biomedical research in national laboratoriesrather than in medical schools as happened in the US and the UK. This should provide separatecenters of excellence within research. However it has often been suggested that the separation of theresearch from daily medical practice had a negative effect on its quality and especially on the rate atwhich it diffused into the medical community (Braun, 1994, Thomas, 1994).172.3.2 Procedures for product approvalA second fundamental change during this second epoch which has changed the competitiveenvironment has to do with the procedures for product approval. Since the early 1960s, mostcountries have steadily increased the stringency of their approval processes. However, it was theUSA, with the Kefauver-Harris Amendment Act in 1962, and the UK, with the Medicine Act in1971, that took by far the most stringent stance early on among industrialized countries. Germanybut especially France, Japan, and Italy have historically been much less demanding. Other countriesfall somewhere in-between.In the USA, the 1962 Kefauver-Harris Amendments introduced a proof-of-efficacyrequirement for approval of new drugs and established regulatory controls over the clinical (human)testing of new drug candidates. Specifically, the amendments required firms to provide substantialevidence of a new drug's efficacy based on "adequate and well controlled trials." As a result, after1962 the FDA (the Federal Drug Administration) shifted from a role as essentially an evaluator ofevidence and research findings at the end of the R&D process to an active participant in the processitself (Grabowski and Vernon, 1983).The effects of the Amendments on innovative activities and market structure have been thesubject of considerable debate (see for instance Chien, 1979, Peltzman, 1974 and Comanor, 1986).They certainly led to 1) large increases in the resources necessary to obtain approval of a new drugapplication (NDA), 2) they probably caused sharp increases in both R&D costs 3) and in thegestation times for new chemical entities (NCEs), 4) along with large declines in the annual rate ofNCE introduction for the industry as well as 5) a lag in the introduction of significant new drugstherapies in the USA when compared to Germany and the UK. However, the creation of a stringentdrug approval process in the U.S. may have also helped create a strong competitive pressurefavouring really innovative firm strategies. In fact, although the process of development andapproval increased costs, it significantly increased barriers to imitation, even after patents expired,thereby penalizing the less innovative firms1.The institutional environment surrounding drug approval in the U.K. was quite similar tothat in the U.S. As in the USA, the introduction of a tougher regulatory environment in the UK wasfollowed by a sharp fall in the number of new drugs launched into Britain and a shakeout of firms inthe industry. A number of smaller, weaker firms exited the market and the proportion of minor localproducts launched into the British market shrunk significantly. The strongest British firms gradually

1Until the Waxman-Hatch Act was passed in the U.S. in 1984, generic versions of drugs that had gone off patent stillhad to undergo extensive human clinical trials before they could be sold in the U.S. market, so that it might be yearsbefore a generic version appeared even once a key patent had expired. In 1980, generics held only 2% of the U.S. drugmarket.18reoriented their R&D activities towards the development of more ambitious, global products(Thomas, 1994). Thus, stringent regulatory changes in the approval process increased thecompetitive pressures within the industry, particularly for the populations of firms either located inthose countries or wishing to sell there. This type of change in government policy directed selectionpressures to favor more innovative - and/or potentially more international – firms.In Continental European countries, procedures for products approval were far less stringent.This allowed the survival of smaller firms specialized in the commercialization of minor domesticproducts. In short, these firms became too protected relative to the changing international standardsof their industry. One hypothesis is that one reason firms from the other European countries havefared better than Continental European firms in the pharmaceutical industry in the third epoch isthat they have faced relatively more stringent regulation, and they also been more internationallyoriented (Thomas, 1994).The development of increasingly demanding and sophisticated clinical trials necessary forthe approval of drugs had a further effect on the pattern of industry-university relations,strengthening the interaction between companies and hospitals linked to medical schools in thedesign and implementation of increasingly scientifically-based trials. In effects, the main channel ofinteraction between pharmaceutical companies and universities continued to be teaching and theprovision of skilled chemists and pharmacologists. Fundamental, basic scientific research playedinstead an important but less crucial role and only few firms surveyed systematically thedevelopments taking place in the “new sciences”.2.3.3 Demand Growth, the Development of Health Care Systems and RegulationA final fundamental change in this second epoch was related to the development of healthcare systems. In general, the rise and consolidation of the Welfare State implied a strong increase inthe demand for drugs. Interestingly enough, these developments took very different forms acrosscountries, and thereby had differentiated effects on the profits of those firms with a significant sharein domestic markets.The USA were the only country where a national health service was not created. Yet, otherfactors – primarily the size of the domestic market and the high prices of drugs - supported a fastgrowth in demand. In the U.S., the fragmented structure of health care markets and the consequentlow bargaining power of buyers further protected pharmaceutical companies' rents from productinnovation. Unlike most European countries (with the exception of Germany and the Netherlands)and Japan, drug prices in the U.S. were unregulated by government intervention. Until themid-1980s the overwhelming majority of drugs were marketed directly to physicians who largelymade the key purchasing decisions by deciding which drug to prescribe. The ultimate customers --19patients -- had little bargaining power, even in those instances where multiple drugs were availablefor the same condition. Because insurance companies generally did not cover prescription drugs (in1960, only 4% of prescription drug expenditures were funded by third-party payers), neither didinsurance companies provide a major source of pricing leverage. Pharmaceutical companies wereafforded a relatively high degree of pricing flexibility. This pricing flexibility, in turn, contributedto the high return, and hence also firm profitability of investments in drug R&D for future block-busters.In most European countries and in Japan, prices of drugs were subject to various forms ofdirect or indirect control, for different reasons.The main reason for price regulation was based on equity considerations. Everybody shouldhave access to drugs, especially (new) expensive ones. A related – but different, because it is arguedin term s of efficiency - argument referred (albeit not always explicitly) to some peculiar featuresof the market for drugs. First, demand elasticity tends to be low, given the value that that users mayattribute to the product, especially in extreme cases. Second, the market for drugs is inherentlycharacterized by information asymmetry. Producers have “more information” on the quality of thedrug than consumers. In fact, it is physicians and not patients that take the decision about the use ofalternative drugs, but even doctors cannot know in detail the properties of a drug, especially when adrug is new. Moreover, it was observed that much of the information available to physicians isprovided by the companies themselves. Producers could then try to exploit this asymmetry bycharging higher prices. Finally, it was usually stressed that producers enjoy monopoly powerthrough patent protection. Price regulation might therefore be justified as a mechanism tocountervail monopolistic pricing. In part, this attitude was reflected in the frequent accusations ofexcessive profits enjoyed by the industry and of aggressive and misleading marketing practices bythe pharmaceutical companies. These issues, for example, figured prominently in the debates withinthe the Kefauver Committee (see Comanor 1986 for a survey).A further set of reasons for price regulation referred to cost containment. In countries wherea national health service exists or when in any case there is a third payer (typically, an insurer),demand elasticity to price tends to be lower than it would otherwise have been the case. This maylead to price increases by firms enjoying market power. Moreover, as a consequence, the absence ofany countervailing measure is likely to lead to an explosion of public expenditures, because neitherthe patients nor the physicians ultimately pay for the drug. Thus, the governments may act asmonopsonist and through various instruments tend to reduce drug prices.Finally, price regulation has sometimes been used (in most cases implicitly) as an industrialpolicy tool, to protect and/or to promote national industries.20In the postwar years, cost consideration certainly played an important role ever since thecreation of the National Health Systems, especially in the UK. However, the belief was diffused thatthe general health conditions would improve over time (mainly as consequence of rising standardsof living) and it seems that other objectives, rather than cost containment per se were considered ascomparatively more important until the 1980s.Both the objectives and the instruments of price controls differed widely across Europeancountries and Japan, according to the role taken by the State as customer of drugs and partlybecause of entrenched different attitudes and expectations about the role of the Welfare State aswell as of deeply ingrained “policy styles” or “routines”In the UK, the Pharmaceutical Price Regulation Scheme, formerly known as Voluntary PriceRegulation Scheme, was established in 1957, and defined a cap to the overall rate of return of firms,regardless the pricing policy on each single product. The profit margin was negotiated by each firmwith the Department of Health and it was designed to assure each of them an appropriate return oncapital investment including research conducted in the UK and was set higher for export orientedfirms. In general, this scheme tended to act as a non-tariff barrier which favored both British andforeign R&D intensive companies which operated directly in the UK. Conversely, it tended topenalize weak, imitative firms as well as those foreign competitors (primarily the Germans) tryingto enter the British market without direct innovative effort in loco (Burstall, 1985, Thomas, 1994).The term “voluntary” expresses quite well the nature of the system: it was not established by law,but firms participated on a voluntary basis, and profit caps were determined and revised throughperiodical bargaining between the Association of British Pharmaceutical Industry and theDepartment of Health and Social Services2. Many scholars have highlighted the peculiarity of thisflexible and informal system, based on permanent forums and mutual recognition and trust, andquite stable over time. However, it has been also noted that firms have long enjoyed a relevantbargaining power, due to informative advantages. This led to the definition of a profit rate cap wellabove the world average, and, on the other side, provided low incentives to reduce costs.Germany (but also other countries like the Netherlands) represents instead an interestingcase in which the presence of universal health insurance, provided by private sickness fund (thesystem dates back to Bismarck era) has not been accompanied by some form of price control.Several explanations, regarding economic as well as more “systemic” factors, have been provided.First of all, as the participation to the fund is compulsory and is financed in large part by employers,there has not been concern about the provision of drugs and other health services for almost all the

2A similar system has been adopted in the regulation of public utilities under private ownership such as electricity andwater supply.21population. Moreover, thanks to the sustained rates of economic growth the issue of costcontainment was not a major one in the political agenda. Thus, drug prices were quite high ascompared to other European countries.France and Japan (and partly Italy), on the contrary, are examples of countries whichadopted policies of direct price control in dealing with the supply side of the market. Moreover,price regulation was organized in such a way to protect the domestic industry from foreigncompetition and this thus offered little incentive to ambitious innovative strategies of firms(Thomas 1994, Henderson, Orsenigo and Pisano 1999). The strategies in these national contextswould instead be to maximize returns under conditions of fairly stable products and prices.In France, under the Cadre de Prix (subsequently called Grille de Prix), a fixed mark up wasdefined on each product, in principle taking into account the innovative characteristics of the drug,in order to enhance research. In practice, prices were simply held down and the system was used tofavour quite openly French firms over foreign competitors.Similar features can be found in the Japanese price control system, which divided productsin four categories, according to their innovative potential, and allowed different levels of mark upbased on price of similar products or, in absence of relevant information, on costs. The Ministry ofHealth and Welfare set the prices of all drugs, but using suggestions from the manufacturer basedon the drug's efficacy and the prices of comparable products. Once fixed, however, the price wasnot been allowed to change over the life of the drug (Mitchell, Roehl and Slattery, 1995). Thus,whereas in many competitive contexts prices began to fall as a product matured, this was not thecase in Japan (as well as in France, that had a very similar system). Given that manufacturing costsoften fall with cumulative experience, old drugs thus probably offered the highest profit margins tomany Japanese companies, further curtailing the incentive to introduce new drugs. Moreovergenerally high prices in the domestic market provided Japanese pharmaceutical companies withample profits and little incentive to expand overseas. Such system (coupled with product approvalprocedures that were quite lax for domestic companies but extremely harsh for foreigncompetitors3) has also been considered a form of industrial policy designed to protect the domesticindustry. A very peculiar aspect of the system, moreover, was the “double” role of the physicians,who both prescribed and dispensed drugs to patients. They were able to negotiate discounts with thepharmaceutical manufacturers, and thus to “pocket” the difference between what they payed and theconsumer did.In both France and Japan, such controls have proven, according to many observers authors,as rather inefficient, in that they tended to reward incremental innovation and “me too” products.22The low number of important NCE discovered, the small average size of firms in the industry andthe limited degree of internationalization, are often considered as effects of such system.In sum, in this second epoch, industrial leadership was based on the combination of strongtechnical and organizational capabilities in the innovative process within innovative firms,competencies (sometimes and in some countries also or even mainly of a “political” nature) in theprocesses of products approval, marketing and distribution. Moreover, the processes and theintensity of competition, largely shaped by institutional factors like patent legislation, proceduresfor product approval and price regulation tended to favour in some cases the more innovation-oriented firms, in other cases the marketing-oriented companies, and even the less efficient smallerfirms mainly operation on domestic, protected markets. It is hard to establish any specific directionof causation – let alone a linear relation - between one particular institutional feature, the nature ofcompetition and the degree of innovativeness. For example, it is by no means clear that priceregulation or weak patent protection had always a negative and discernible effect on the incentivesand the ability to innovate. For example, the British system of price regulation worked pretty well ininducing a virtuous circle between competition, incentives and innovative capabilities. Rather,specific combinations of these variables conjured to produce particular competitive environmentsfavouring the adoption of innovative strategies. Moreover, it worth noting that many of theseinstitutional arrangements were not devised with the explicit aim of favouring innovation or evenindustrial prowess. Rather, they resulted from totally different purposes - like social policies - butended up – after sometimes quite prolonged periods of time - bearing important consequences onthe capacity and willingness to innovate.3. The Advent of Molecular Biology and the Age of Cost-ContainmentThe third epoch in our characterization runs from the early 1980s through the present. Thisepoch started with the advent of the knowledge revolution to pharmaceuticals associated withmolecular biology as well as shifts in the nature of demand4.Beginning in the early Seventies, the industry also began to benefit more directly from theexplosion in public funding for health related research that followed the war. The development ofnew knowledge bases in modern biotechnology as well as in fundamental biological and medical

3Foreign companies had to carry clinical trials in Japan, under rules that specified that the drug should satisfy thespecial characteristics of the Japanese population.4Although the earliest scientific expressions of molecular biology were visible from the mid-1970s and somepharmaceutical companies were quick to explore this route, we have set the rough period of the third epoch from theearly 1980s through the present to take into account of when more major impacts of modern biotechnology were feltwithin pharmaceuticals.23areas transformed radically the cognitive and organizational nature of the processes of learning anddiscovery. Moreover, if firms wished to create and sustain learning processes within these newknowledge bases, they had to be part of a new system, with new structure of incentives.This section concentrates on discussing how and why changes in the knowledge bases and inthe related “learning regime” have altered the structure of the sectoral system of innovation,especially when put in relation to the changing nature of demand. Moreover, this section addressessome of the main consequences of such a shift for explaining the relative competitiveness of thepopulation of firms in biotechnology-pharmaceuticals in different countries. The main comparisonis again between Continental Europe and Anglo-Saxon countries, with some reference to the smallopen economies of Europe.3.1 The Scientific revolution and the new learning regimeFrom the middle Seventies on, substantial advances in physiology, pharmacology,enzymology and cell biology -- the vast majority stemming from publicly funded research -- led toenormous progress in the ability to understand the mechanism of action of some existing drugs aswell as the biochemical and molecular roots of many diseases. This new knowledge and relatedtechniques and equipment had a profound impact on the process of discovery of new drugs withinpharmaceutical firms. First, these advances offered researchers a significantly more effective way toscreen compounds. In turn the more sensitive screens made it possible to screen a wider range ofcompounds, triggering a "virtuous cycle" of discovery and understanding. In other words, theavailability of drugs whose mechanisms of action was well known made possible significantadvances in the medical understanding of the natural history of a number of key diseases. Theseadvances in turn opened up new targets and opportunities for drug therapy. Combining medicalunderstanding with an understanding of disease and drug action enabled the firms to concentrate onareas likely to give further returns. This can be called 'guided search'.These techniques of "guided search" made use of the knowledge that a particular chemicalpathway was fundamental to a particular physiological mechanism. If, to use one common analogy,the action of a drug on a receptor in the body is similar to that of a key fitting into a lock, advancesin scientific knowledge in the seventies and eighties greatly increased knowledge of which "locks"might be important, thus making the screening process much more precise. This implies that thefirm R&D process itself can become more efficient through search within a more precise and betterdefined search space (McKelvey 1997). Following the continuos advances in basic science, thisprocess has become more efficient over time and, more recently, it has led to an improvedunderstanding of what suitable "keys" might look like. Chemists are now beginning to be able to24"design" compounds that might have particular therapeutic effects. The techniques of "rational drugdesign" are the result of applying the new biological knowledge to the design of new compounds, aswell as applying it to the ways in which the compounds are screened.Knowledge advances, however, had no automatic effect on the strategies andcompetitiveness of any given firm. Or, to put it the other way, these techniques were not uniformlyadopted across the industry. For any particular firm, the shift in the technology of drug researchfrom "random screening" to one of "guided" discovery or "drug discovery by design" was criticallydependent on the ability to take advantage of publicly generated knowledge (Gambardella, 1995;Cockburn and Henderson, 1996) and of economies of scope within the firm (Henderson andCockburn, 1996). Smaller firms, those farther from the centers of public research and those thatwere most successful with the older techniques of drug discovery appear to have been much slowerto adopt the new techniques than their rivals (Gambardella, 1995; Henderson and Cockburn, 1994;).There was also significant geographical variation in adoption. While the larger firms in the US, theUK and Switzerland were amongst the pioneers of the new technology, other Continental Europeanand Japanese firms appear to have been slow responding to the opportunities afforded by the newscience. In Scandinavia, however, some firms were in quite quickly. These differences in the initialchanges within drug development techniques seems to have significant implications for the laterresponse of the population of pharmaceutical firms to the revolution in molecular biology.This transition towards new techniques of drug discovery was in mid-course whenmolecular genetics and rDNA technology opened an entirely new frontier for pharmaceuticalinnovation. The application of these advances initially followed two relatively distinct technicaltrajectories. One trajectory was rooted in the use of genetic engineering as a process technology tomanufacture proteins whose existing therapeutic qualities were already quite well understood inlarge enough quantities to permit their development as therapeutic agents (McKelvey 1996). Thesecond trajectory used advances in genetics and molecular biology as tools to enhance theproductivity of the discovery of conventional “small molecule” synthetic chemical drugs. Morerecently, as the industry has gained experience with the new technologies, these two trajectorieshave converged.More recently, technologies such as genomics, gene sequencing, transgenic animals, andmolecular biology have started to supply the industry with a huge number of novel biologicaltargets thought to be relevant to a vast array of diseases defined at the molecular level, and todevelop highly sensitive assays incorporating these targets. Against this background, during theEighties and Nineties new developments in a variety of research areas has affected both the searchand testing phases of pharmaceutical research and development. These advances include a variety25of things, such as solution phase and solid phase chemistries, high-throughput screeningtechnologies (HTS), information technologies, and combinatorial chemistry. These have led to thedevelopment of a set of research technologies that allow to achieve a higher breadth of applications,measured in terms of the number of disease areas and biological targets to which the firm mayapply these technology.One of the important consequences of these parallel improvements in knowledge, techniquesand equipment in a variety of fields is that a larger number of targets can be tested, even if each oneis thought to be more likely to be relevant for something. For example, the methods of conventionalmedicinal chemistry could not allow the company to test several thousand genetic targets, but thedevelopment of combinatorial chemistry libraries, together with new techniques for high-throughput screening and ever-improving bio- informatics tools, has gradually made it possible totest a large number of potential drug targets against an even larger number of chemical entities5?This move towards large numbers has been accompanied by knowledge development which alsoincreases the speed at which each is tested. Thus, more generally, during the Nineties, a set ofgeneric research technologies has been developed (from PCR, to protein structure modeling, rapidcomputer based drug assay and testing, recombinant chemistry techniques, drug delivery systems,chemical separation and purification techniques) that allow researchers to screen thousands ofpotentially promising compounds at an unprecedented speed.The appearance of these new family of technologies has introduced a further distinction inthe (co-existing) search regimes characterizing contemporary pharmaceutical R&D. The firstregime is essentially based on biological hypotheses and molecules that tend to be specific to givenfields of application (co-specialized technologies) while the second regime is characterized by theemergence of new generic tools useful in searches based on the law of large numbers (labeled in theliterature as transversal or generic or platform technologies).In the case of co-specialized research hypotheses and molecules, the characterization ofbiological targets and the corresponding design/experimentation of each new drug tends to requireindividual analysis. Lessons learned from the design and experimentation of one biologicalhypothesis/molecule cannot be immediately transferred to other biological domains, in order todevelop other classes of drugs. Conversely, transversal technologies are in principle applicable to

5Combinatorial chemistry enables rapid and systematic assembling of a variety of molecular entities, or buildingblocks, in many different combinations to create tens of thousands of diverse compounds that can be tested in drugdiscovery screening assays to identify potential lead compounds. Large libraries are available to be tested against bothestablished and novel targets to yield potential lead compounds for new medicines. Such vast numbers of compoundshave been introducing a substantial challenge to the drug discovery process and have created a need for faster and moreefficient screening. High-throughput screening ( HTS ) methods make it possible to screen vast populations ofcompounds via automated instrumentation: that is, complex workstations capable of performing several functions withthe help of mechanical arms or simpler automated dilution devices.26multiple biological targets and diseases. The search space is possible across many applications, buthave to made specific for each use (Orsenigo, Pammolli and Riccaboni, 2001).These changes in the knowledge bases have been here been described as particularlyrelevant to pharmaceutical firms in the drug discovery and development phases. These shifts were,moreover, partly exogenous to the pharmaceutical sector in the sense that fundamental research andaccess to relevant materials, techniques and equipment might come outside the search activities ofthe firms themselves. At the same time, these shifts have been endogenous in that their adaptation -and further modification to be relevant to the concerns of business - have occurred within firms.Taken together, this section has described them as a new learning regime, which the next sectionargues is relevant for determining the industrial structure as well as the division of knowledge laborwithin the international pharmaceutical sectoral system of innovation.3.2 From learning regime to organization of innovative activities within and across firmsIn this third epoch, the advent of modern “biotechnology” has had a significant impact onboth the organizational competencies required to be a successful player in the pharmaceuticalindustry and on industry structure in general. The co-evolution of knowledge, institutions andorganizational forms of research within the pharmaceutical sectoral system of innovation has alsoinfluenced the relative success and failure of specific firms trying to adapt and influence the newlearning regime.As compared to the “random screening regime” of the second epoch, the new learningregime found in our third epoch has required different learning and discovery procedures. Basically,the new knowledge bases have influenced the organizational structure of innovative activities, bothas distributed within firms as well as distributed across different firms and non-firm organizationswithin this sectoral system. The reason the organizational structure has changed in such significantways is that new knowledge bases have led to a new structure of the search space, new definitionsof the problems to be solved, other heuristics and routines used to solve such problems. For reasonsargued below, these changes in turn have lead to a redesign of the patterns of division of labour, todifferent incentive structures and selection mechanisms.The process of transition to the new paradigm marks the shift which defines this third epoch.This transformation occurred much more quickly in the USA than in particularly ContinentalEurope, while also taking profoundly different forms. In understanding these shifts, it is importantto break the discussion into new biotechnology firms as compared to established pharmaceuticalfirms, mainly in order to later identify their respective, specialized roles within the sectoral system27of innovation. Moreover, we shall deal first with the American case and then we suggest somehypotheses as to why Europe lagged behind.3.2.1 New Biotechnology FirmsThe most noticeable manifestation of the transformations occurring in the pharmaceuticalSSI has been the appearance of a new breed of agents, i.e. new specialized biotechnology firms(NBFs). As in many other technologies, innovation was firstly pursued not by incumbents but bynew companies. In the United States, biotechnology was the motive force behind the first largescale entry into the pharmaceutical industry since the early post World War II period. The first newbiotechnology start-up, Genentech, was founded in 1976 by Herbert Boyer (one of the scientistswho developed the recombinant DNA technique) and Robert Swanson, a venture capitalist.Genentech constituted the model for most of the new firms. They were primarily universityspin-offs and they were usually formed through collaboration between scientists and professionalmanagers, backed by venture capital. Their specific skills resided in the knowledge of the newtechniques and in the research capabilities in that area. The “function” of this type of NBF has beento mobilize fundamental knowledge created in universities and to transform it into potentiallycommercially useful techniques and products. Their aim consisted in applying the new scientificdiscoveries to commercial drug development, focussing on two main directions: diagnostics, on thebasis of monoclonal antibodies, and therapeutics.It is indeed interesting to ask why the transfer of fundamental, academic knowledge toindustry involved the creation of new organizational entities like the NBFs rather than some sort ofdirect relationship between large pharmaceutical firms and universities. At this stage, let us justremark that the internal organizational structure of the NBFs reflected their origin andcompetencies. They were organized very much like academic units and they deeply embodied somefundamental academic principles like the importance attributed to publication and to work at thefrontier of knowledge. However, these organizational principles (in terms of norms, incentives,practices) had to be made consistent with their commercial nature too. Thus, secrecy and the searchfor broad property rights became crucial features of these new firms. Moreover, financialconstraints coupled with their high burn rates have made “time to patent” a characteristic feature ofthe research style of these companies.Genentech was quickly followed by a large number of new entrants. Entry rates soared in1980 and remained at a very high level thereafter, but with waves linked to both the stock marketperformance and to the appearance of successive new technologies. Despite the high rates of entryof new firms into biotechnology, it took several years before the biotechnology industry started tohave an impact on the pharmaceutical market. Many of the early trajectories of research proved to28be dead-ends and/or much more difficult to develop than expected, as for example in the case ofinterferon6. Note, however, that while NBFs have transformed pharmaceutical industry world-wide,much of the motor of change within modern biotechnology has occurred in the USA. More NBFshave been started in the USA, and they tend to have agreements with pharmaceutical firms aroundthe globe.While biotechnology related products became integrated with pharmaceuticals, the largemajority of these new companies never managed to become a fully integrated drug producer. Thegrowth of NBFs as pharmaceutical companies was constrained by the need to develop competenciesin different crucial areas, including both scale and scope of knowledge bases as well ascomplementary assets.First, as far as the first generation of NBFs is concerned, they found it necessary tounderstand better the biological processes involved by proteins and to identify the specifictherapeutic effects of such proteins. Companies, in fact, turned immediately to produce thoseproteins (e.g. insulin and the growth hormones) which were sufficiently well known. Thesubsequent progress of individual firms and of the industry as a whole was however predicated onthe hope of being able to develop much deeper knowledge of the working of other proteins inrelation to specific diseases. Yet, progress along this line proved more difficult - and moreexpensive - than expected.Second, these companies often lacked competencies in other different crucial aspects of theinnovative process: in particular, knowledge and experience of clinical testing and other proceduresrelated to product approval on the one hand and marketing on the other. Some like Genentechworked to hire a range of persons with appropriate skills while others remained more specialized intheir activities. Thus, many of these NBFs have exploited their basic competence and actedprimarily as research companies and specialized suppliers of high technology intermediate products,performing contract research for and in collaboration with established pharmaceutical corporations.Third, even remaining at the level of pre-clinical R&D, most NBFs lacked crucialcompetencies in a rather different way. In fact, many individual NBFs were actually started on thebasis of a specific hypothesis or technique, following the processes of growth of knowledge in the

6The first biotechnology product, human insulin, was approved in 1982, and between 1982 and 1992, 16biotechnology drugs were approved for the US market. As is the case for small molecular weight drugs, the distributionof sales of biotechnology products is highly skewed. Three products were major commercial successes: insulin(Genentech and Eli Lilly), tPA (Genentech in 1987) and erythropoietin (Amgen and Ortho in 1989). By 1991 there wereover 100 biotechnology drugs in clinical development and 21 biotechnology drugs with submitted applications to theFDA (Pharmaceutical Manufacturers Association, 1991, Grabowski and Vernon, 1994): this was roughly one third ofall drugs in clinical trials (Bienz-Tadmore et al.,1992). Sales of biotechnology-derived therapeutic drugs and vaccineshad reached $2 billion, and two new biotechnology firms, (Genentech and Amgen) have entered the club of the topeight major pharmaceutical innovators (Grabowski and Vernon, 1994).29field. Such processes entailed the proliferation and branching of alternative hypotheses at increasinglevels of specificity (Orsenigo,Pammolli and Riccaboni, 2001). Thus, successive generations ofNBFs were increasingly specialized in particular fields and techniques and, with few exceptions,they were stuck in specific cognitive /research niches. The reason this specialization worked counterto becoming a fully integrated pharmaceutical company is that the process of drug discovery (anddevelopment) still requires a broader and more “general” perspective, which integrates several. Thisbroader perspective is necessary on many fronts, including alternative routes to the discovery ofparticular classes of drugs, the cognitive complementarities among different techniques and bodiesof knowledge, and the realization and exploitation of economies of scope.Indeed, later generations of NBFs (and the new “stars” like Affymax, Incyte and Celera)were largely created on the basis of specialization into radically different new technologies likegenomics, gene therapy, combinatorial chemistry and what is now called “platform technologies”.These technologies are essentially research tools and the companies developing them do not aim tobecome drug producers, but providers of services to the corporations involved in drug discoveryand development. As argued for example by Steve Casper and Hannah Kettler (YEAR), thesecompanies are characterized by radically different risk profiles, having a potentially larger marketand avoiding problems of conducting clinical trials. They may thus be able to sell specializedservices to a wider range of potential buyers - which would generally be other companies ratherthan the end user patients / doctors.This outline of the changing fortunes of NBFs allows us to see some of the relative strengthsand weaknesses of NBFs as compared to integrated pharmaceutical companies. Collaborationallowed NBFs to survive and - in some cases - to pave the way for subsequent growth in manyrespects. First, clearly, collaboration with large companies provided the financial resourcesnecessary to fund R&D. Second, it provided the access to organizational capabilities in productdevelopment and marketing. Established companies faced the opposite problem. While they neededto explore, acquire and develop the new knowledge, they had the experience and the structuresnecessary to control testing, production and marketing. Both companies also wanted collaborationwith the relevant basic scientific communities, in order to gain access to new sources of knowledge.3.2.2 The adoption of molecular biology by established companiesIndeed, large established firms approached these new scientific developments mainly froma different perspective, i.e. as tools to enhance the productivity of the discovery of conventional“small molecule” synthetic chemical drugs. These differences help explain why the largeestablished pharmaceutical firms have not been overtaken by the specialized biotechnology firms -and have instead found specialized and complementary roles within the system.30For the large pharmaceutical firms, the tools of genetic engineering were initially employedas another source of "screens" with which to search for new drugs. Their use in this mannerrequired a very substantial extension of the range of scientific skills employed by the firm; ascientific work force that was tightly connected the larger scientific community and anorganizational structure that supported a rich and rapid exchange of scientific knowledge across thefirm (Gambardella, 1995; Henderson and Cockburn, 1994). The new techniques also significantlyincreased returns to the scope of the research effort (Henderson and Cockburn, 1996). In turn, thisrequired the adoption of organizational practices and incentive structures which in some wayattempted to replicate some of the typical characteristics of an academic environment. According toCockburn, Henderson and Stern (1999), the new organization of R&D implied “new mechanismsfor monitoring and for promotion, different ways to organizing researchers into teams, recruitingnew types of human capital, and different types of interactions with researchers external to firm”.In fact, the molecular biology revolution made innovative capabilities critically dependent